Canada's Growth Sets Stage for Rate Increase

By

Phred Dvorak

Updated June 1, 2010 2:27 am ET

Canada's economy grew at the fastest pace in more than a decade during the first quarter of this year, a stronger-than-expected performance that cemented expectations of an interest-rate increase on Tuesday.

Gross domestic product rose an annualized 6.1% during the three months ended March 31, fueled by continued growth in consumer spending and manufacturing, Statistics Canada said. That growth was more than double what the U.S. economy reported during the same period, and stronger than both the Bank of Canada and analysts' consensus forecasts of 5.8%. It contrasts sharply with an annualized contraction of 7% a year earlier, in the first quarter of 2009.

The strong performance highlights how Canada's healthy financial system and relatively unscathed consumers have underpinned a fast rebound from the downturn of the past two years. Consumer price levels, job creation and housing sales are all rising in Canada, pointing to a solid recovery, even as peers like the U.S. see falling inflation and uncertain consumer demand.

The robust economic growth also sets the stage for what is expected to be the first interest-rate increase among the Group of Seven wealthy nations following the financial crisis. The Bank of Canada is widely expected to say at its Tuesday policy announcement that it is raising its target overnight interest rate by 25 basis points, or hundredths of a percentage point, to 0.5%. Many expect that tightening to continue, raising the overnight rate to 1.5% by the end of the year, according to a survey of economists by Dow Jones.

Some central bank watchers warn there are risks to tightening interest rates in Canada now. The situation in Europe remains volatile after fears of a Greek debt default prompted a bailout from the European Union, followed by credit downgrades of countries such as Spain and Portugal. Banks report that credit is tightening again and global equity markets have weakened.

"Even though the lagging economic data have improved measurably, there has already been enough of a tightening of economic conditions to allow the bank to sit back and assess how the debt crisis unfolds," says
David Rosenberg,
chief economist at wealth manager Gluskin Sheff & Associates Inc. in Toronto.

Mr. Rosenberg warns that if the Bank of Canada raises rates and global credit markets weaken further, it may have to reverse course, as it did in 2002—the last time it raised rates ahead of the U.S. Federal Reserve.

Most economists also expect Canada's growth to cool down on its own. Some measures that the government implemented to boost consumption—including a popular tax break on home renovations—have expired. Roaring housing sales are slowing as mortgage rates and prices rise. Canada is unlikely to sustain the rapid inventory buildups and high levels of consumer demand that characterized the first quarter, says
Douglas Porter,
an economist at BMO Capital Markets in Toronto, who is forecasting GDP growth of 3.4% for all of 2010.

Mr. Porter, though, still expects the Bank of Canada to start raising rates on Tuesday—even if it pauses later in the year.

"I have a lot of empathy for how hard the decision is," he says. "But I think the domestic case is so strong that they should be raising interest rates."

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Canada's Growth Sets Stage for Rate Increase

Canada's economy grew at the fastest pace in more than a decade during the first quarter of this year, a stronger-than-expected performance that cemented expectations of an interest-rate increase on Tuesday.